Chris Lau - Seeking Alpha

Monday, May 24, 2010

Notes from Author of $2,397 Book (Amazon.com)

Seth Klarman recently made a speech at the CFA Conference in Boston last week. This speech was transcribed and posted on marketfolly.com.

Note: I am providing hedge fund analysis to marketfolly.com. Articles (co-analyzed/commented by Marketfolly) will appear on the Marketfolly site. The site has nearly 10,000 subscribers and x000,000 hits per month.

As you will recall, Klarman is author of 'Margin of Safety' and Fund Manager at Baupost Group. The fund has $20 billion in assets under management.

Klarman provides great insight on such things as group think, on taking action through courage.

On Conviction and Courage

So what do we do to give us conviction?
1.) Find compelling bargains, not slight bargains.
2.) Test everything with sensitivity analyses.
3.) Prepare to be wrong. It’s not courage, it’s Arrogance, when you buy something, you’re saying you’re smarter than everyone else. We realize we have lots of smart competition and temper our arrogance with humility to realize that many things could go wrong.

Our own confidence matters, and we’re highly disciplined buyers and sellers to avoid round trips and take advantage of short term sell offs.

Jason Zweig: So Investors need cash and courage?Klarman: Courage is a function of process.

On Group Think
One observation that can be made (at the danger of making false generalizations) is about large companies. Why is Microsoft referred to as "the evil empire?" Does a company become "evil" as it gets larger?

A company can get "dumber" as it gets larger. The same phenomenon is applicable in the group analysis of securities:

Zweig: How do you avoid group think?
(my emphasis in bold)

Klarman: We recently had an investment team retreat with leading thinkers. They all said
there was a terrible problem with paper money, we should consider gold, the EU
would break up. Our partner’s immediate thought was that gold was a group
thought and we should be cautious holding it.

So we focus on intellectual honesty and try to learn from mistakes, accept them, and move on. We spend a lot of time on this in our hiring process. When there’s a mistake, there is no yelling, it’s never the analyst’s fault (unless it’s a dumb formula error, etc), everything is reviewed by senior people and we’re wrong together. We’re aware of our biases and the risk of being biased. As an investor you need to decide if you’d rather make more money
in up years and have a few bad years, or protect your downside, and we’ve obviously
chosen the latter. We’d rather under-perform a huge bull market then get clobbered
in a bear.

On Intellectual Honesty

Zweig: Everyone says it’s never the analyst’s fault, but often they don’t stick to this
when something goes wrong. How do you screen for Intellectual Honesty in your
hiring process?

Klarman: We ask about their biggest mistake, which doesn’t have to be investing related. But if you say your biggest mistake is wearing mis-matched socks one day, then
that’s likely not being intellectually honest.

We ask ethical questions, ask them how they’d respond in morally ambiguous situations, we want to see that they realize conflicts can exist. We want people who fit in. One key thing is idea fluency, if I present a thesis I want people to immediately come up with 10 places to look to exploit it, I don’t want them sitting at their desk thinking, “hmm, where should I look?”